VOL. 11 NO.

2 (2023)

https://jiae.ub.ac.id/

LITERATURE REVIEW ON THEORIES OF INTERNATIONAL TRADE AND

POLICIES BEHIND MODERN WORLD TRADE
1
Bharat, 2Vijay Kumar, 3Sachin Sharma, 4Shallu Sehgal, 5Babloo Jakhar
1
Centre for Economic Studies and Planning (CESP), Jawaharlal Nehru University, New Delhi, India
2,3
Department of Economics, Chaudhary Ranbir Singh University, Jind, Haryana
4
Shoolini Institute of Life Sciences and Business Management, Solan, Himachal Pradesh
5
Department of Extension Education, Regional Institute of Education, Ajmer, India

Corresponding author:
[email protected]

Abstract
Purpose
The essay aims to critically examine different theories proposed in the literature on
international trade.
Design/methodology/approach
The essay is based on theoretical literature on the theories of international trade and working
policies behind modern world trade globally
Findings
The essay discusses traditional international trade theories, mercantilist patterns, simplified
models, new trade theories, strategic trade policies by advanced countries, FDI and technology
role, and trade's impact on growth. It also discusses 21st-century theories, advocating for
models that incorporate income inequality, political strategies, and real-world factors, and calls
for models that incorporate income inequality and other real-world factors.
Research limitations/implications
The essay deals with only theoretical literature on international trade theories and policies.
Findings and interpretation are subject to the theoretical development of international trade
Originality/value
The essay provided a critical explanation of international trade theories and tried to explain the
paradigm shift in the theoretical framework of international trade.

Keywords: International trade, trade and policy, trade theories, trade, growth.

HOW TO CITE ARTICLE HISTORY

Bharat, Kumar, V., Sharma, S., Sehgal, S. & Jakhar, B. Received : August 4, 2022
(2023). Literature Review on Theories of International Published : August 31, 2023
Trade and Policies Behind Modern World Trade. Journal
of Indonesian Applied Economics, 11(2), 184-192.

DOI: doi.org/10.21776/ub.jiae.2023.011.02.6

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1. INTRODUCTION
One of the traps people often fall into in the area of economics, particularly when it
comes to global economics, is thinking that history always moves in one direction, i.e., the
world is getting more global. But, when we look at history, we find out that international
trade has been a story of ups and downs. It is often assumed that globalization is a new
phenomenon and that until recently, there was very little trade between different parts of the
world. It turns out, however, that there was a tremendous amount of trade between countries
even on opposite sides of the world. People in England, for example, regularly ate lamb and
mutton raised in New Zealand. That globalized economy crashed between World War I and
World War II, as restrictions and wars made trade dangerous. By 1950, the increases in
tariffs and import quotas reduced global trade volume to levels equal to those before the
revolution of steamships and railroads. Slowly, nations began reducing those restrictions.
By 1980, trade had recovered to roughly the level it was in 1913, just before the outbreak of
World War I. After the 1990s, trade picked up the pace as seen in the era of hyper-
globalization. These up-downs in the history of international trade also impacted the various
explanations provided till now, explaining the pattern and reason of trade. This article gives
a gist of literature from traditional theories to new trade theories. While providing details of
theories in trade literature through no. of coming sections, this essay concludes with an
account of theories that explain the pattern of trade in the 21st century.

2. LITERATURE REVIEW
Across the literature, a number of theories have been identified for analysis. The
dominant theories include absolute advantage, comparative cost advantage, factor
endowment theories, technological gap theories, intra-industry trade theories, new trade
theories, Dutch disease, trade theories of the twenty-first century, etc. The essay mainly
deals with literature review on trade theory and policies behind modern world trade. It starts
with traditional theories of international trade, i.e., mercantilism, physiocrats, absolute
advantage theory of international trade by Adam Smith (1776), and comparative advantage
of international trade by David Recardo (1817). The factor endowment model was also the
base of international trade according to twentieth-century economists, developed by
Heckscher and Ohlin and later Samuelson, (in short, HOS) is two countries, two
commodities, and two factors of the production model, assuming constant returns to scale.
This model has brought factor endowments of the countries to the center of trade theories
(Feenstra,2004; Leamer, 1995; Ohlin, 1967). Further, new trade theories, intra-industry
trade, and 21st-century trade theory have their importance in literature. The detailed
literature review is elaborated in the findings section of this essay.

3. RESEARCH METHODS
This section presents the methodological framework of the study. The theoretical
review is based on available literature on classical as well as modern world trade theories
and practices. We have examined these trade theories in a critical way and tried to formulate
conclusions. The nature of this essay is descriptive cum- critical interpretation of trade
theories. Interpretative and descriptive method was used for the present write-up. Further,
an analysis of these theories was done based on merits and demerits and how one theory has
advancement over other theories. This Essay tells us about the journey of the development
of international trade theories and explained (on what ground) how one theory is different
from others.

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4. FINDINGS
International trade theories are simply different theories to explain international trade.
Trade is the concept of exchanging goods and services between two or more countries. In
the present essay, we have discussed about traditional trade theories, factor endowment
theories, new trade theories, intra-industry trade, role of technology and FDI, effect of trade
on growth, Dutch disease and curse of natural resources, and trade theories in twenty first
century. The detailed interpretation is given in sub-sections as follows:

4.1. Traditional Theories of International Trade

Looking at the evolution of international trade and theories, we found the origin of
trade theories from Mercantilists, often left out of literature. Mercantilists' work style
states a lot about their theory in practice. Coming from the 17th century, they believed
that the best thing to do was export and avoid import which would give them more
bullion, which is the sole measure of gain and welfare. This implicitly implies that trade
was based on a framework of protectionist policies (Braudel, 1979; McCusker, 2001).
The eighteenth-century economists, called ‘physiocrats’ analysed the ‘circular flow of
wealth’ in an economy in an aggregative framework. Francois Quesnay’s Tableau
Economique (1758) is regarded as one of the most remarkable macroeconomic models
of the early days. This concept was developed in France and characterized chiefly by a
belief that government policy should not interfere with the operation of natural
economic laws and that land is the source of all wealth. Physiocrats attacked on
mercantilists not only for its mass of economic regulations but also for its emphasis on
manufacturers and foreign trade. Whereas mercantilists held that each nation must
regulate trade and manufacturer to increase its wealth and power, the physiocrats
contended that labour and commerce should be free from all restraints (Charbit &
Arundhati, 2002; Muller, 1978).
With the Industrial Revolution, new theories witnessed a major change over
mercantilism and Physiocrats in economic literature. Adam Smith’s publication of
Wealth of Nations (1776) marked the evolution of standardized trade theories. Each
country makes the goods in which it has an absolute advantage over others, which
comes from a division of labor as explained by pin factory, diverted from the view of
‘only export’ with attention drawn to import. The domestic economy being the source
of wealth, the purpose of trade was to export more so that more could be imported,
raising overall welfare.
Further development came from the theory of comparative advantage in David
Ricardo’s “On the Principles of Political Economy and Taxation” (1817). As explained
through the famous example of England and Portugal trading wine and cloth, it was not
an absolute advantage but the comparative advantage which was necessary as well as
sufficient condition for trade. According to him, a country has the comparative
advantage in producing a good if the opportunity cost of producing that good in terms
of other good is lower in that country than it is in other country. Hence, trade would be
beneficial for both the trading countries. Smith and Ricardo introduced the notion of
using simplified models for understanding economic issues on trade; they both made a
case for free trade, as opposed to the existing Mercantilist theories of protection. It was
proposed that letting the trade flow, it would make everybody richer.
Interestingly, Ricardo neglected to include aspects of income distribution in his
theory. Ricardo knew that if England opened to free trade, it would benefit the workers
who worked in England’s cloth industry but hurt the aristocrats who owned most of
England’s agricultural land. But still, his theories are powerful and excellent at

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explaining why trade occurs between countries that specialize in very different types of
products.

4.2. Factor Endowment Model of Trade

Developed by Heckscher and Ohlin and later Samuelson, (in short, HOS) is two
countries, two commodities, and two factors of the production model, assuming
constant returns to scale. This model has brought factor endowments of the countries
to the center of trade theories. By linking trade patterns to factor endowments and
production methods, trade theory has driven apart from technology-based
interpretations of the Ricardian comparative cost model. The Ricardian model states
that countries specialize in goods in which they hold the greatest relative advantage.
The Heckscher-Ohlin model ignores differences in total factor productivity across
industries, and it is assumed that all countries possess the same technology in a given
industry. It predicts that countries will produce relatively more of the goods that use
their relatively abundant factors intensively (Clifton & Marxsen, 1974). With the
assumption of the same preferences across countries, factor endowments of different
nations along with factor intensities of commodities was responsible for setting up the
price of commodities. For example, if country A has a capital abundance and produces
capital goods intensive good X, then the price of good X will be lower compared to
other countries. From the theorem of factor-price equalization of this model, we get to
know that as factors are immobile across countries, trade through the commodity price
equalization also leads to the factor price equalization of countries.
A corollary to this theorem relates to protection and real wages. It stated that under
the doctrine of free and factor price equalization trade, scarce factors of trading nations
end up losing more. In other words, capital, considered a scarce factor, will benefit
more from protection than free trade under this model.
Despite the wider uses of this model in trade policies, very little empirical evidence
supports this model. This model's assumptions failed to cope with the realities of the
world. Even with the trade, there is no evidence of prices getting equalized across
countries. Leontief's paradox indicated that most of the trade happens between similar
countries. US import substitute goods consisted of capital-intensive goods, while
exports were labor-intensive. After this, various explanations have been given, citing
the skilled labor force of the US, which is in demand compared to its trading partners.

4.3. New Trade Theory

There was a kind of undercurrent of discontent among people who have worked
with trade data. Traditional theories were insightful but did not provide a complete
picture of the trade patterns observed between countries. A lot of trade was between
similar economies, for example, trade between US & EU, US-Canada trade makes for
the case. This led to the rise of new trade theories, in which trade was driven not only
by inherent differences in productivity but also by the fact that economies of scale
favored concentrating production in one place. Increasing returns internal to firms gave
rise to monopoly/oligopoly market structure, which inherently led to product
differentiation. With all these changes mentioned above, the new trade theory deviates
from the critical assumptions of constant return, perfect competition, and homogenous
goods, which were the founding stone of the Ricardian and HOS model (Shiozawa,
2017; Ranjan, & Raychaudhuri, 2016). With the rise of oligopolistic markets, theories
on strategic trade were also highlighted, drawing the attention of policymakers of
advanced countries. The literature draws a line of difference between national and
international economies of scale. These are further classified into internal and external

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to a firm. For internal economies at an international level, the production achieves a

global span in terms of location. The emergence of global value chains ensures the
dislocating of production to cost-efficient countries. Increasing returns to scale has also
been seen as a time factor with static and dynamic economies of scale classifications.
So, it is not the current economies of scale. Still, those arising from the process of
learning by doing should also be considered for deciding the industry for specialization
and framing of trade policies by countries (Kenneth Arrow,1956). The major problem
that cornered the new trade theory was the predictive power of the pattern of trade by
traditional theories. Possibilities of multiple equilibria due to increasing returns and
strategic patterns adopted by firms were disruptive in predicting the pattern of trade by
new trade theories. Thus, trade can either result in benefits or a loss, with economies
of scale for nations depending on their ability to reap economies. If a country is stuck
with the small market of increasing returns goods, then there is a high probability of
incurring a loss from trade.

4.4. Intra Industry Trade and Strategic Element of New Trade Theory
The desire for varieties produced by the same industries opens space for intra-
industry trade (Veeramani, 2002). Due to different demand elasticities prevailing in
different countries for the same good, intra-industry trade helps extend the benefits of
monopolistic competition. Complete specialization and segmented markets helping in
the dumping of exports also explain the case of two-way intra-industry trade. Soon the
patterns of reciprocal dumping emerged, leading to the formulation of “Strategic trade
theory” by Brander and Spencer (1985), which is explained by the famous example of
Airbus and Boeing. Due to the presence of internal economies of scale at the national
level, countries that are historically ahead of others in producing goods have the edge
over others, i.e., they reach an optimal position in the market first at which they can
produce at a much lower price compared to what other countries can offer in the
beginning. It is not only about the first-mover benefit, but the first-mover should be
able to move at a fast speed and large scale (Aggarwal, 2023). This strategic element
of trade theory has become popular in advanced countries' policies, where different
tactics are adopted to deter other countries from taking first-mover advantage.

4.5. Role of Technology and FDI in Trade

Technology and FDI find an adequate existence in trade theories explaining the
pattern of trade. With the Product Life Cycle (PLC) attracting attention, it showed how
at the innovation stage, the country which is a source of that innovation supplies those
goods to the rest of the world. As product moves to mature and standardized stages,
technology diffuses to the rest of the world (Charles, 2007). The innovator country also
starts importing the varieties or other cheaper versions of the original good. This
explains that countries trade because they are at different levels of the production cycle.
The Technology gap model further extended this concept. All countries are not at the
same level of technology, and there occurs transmission of technology from one country
to another through FDI, lease, or engaging in R&D. Developing Countries always want
to climb higher on the technology ladder. Advanced countries with the abuse of power
and politics try to maintain their position on the technology ladder by deterring others
from climbing it. They know that losing their position on the technology ladder will
worsen the country, affecting their real exchange rate. In this whole process, the FDI
trade nexus has also to be kept in mind. Empirical evidence shows that countries that
received large amounts of FDI also have rapid diffusion of technology and higher
growth rate. The flow of an enormous amount of foreign investment and international

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economies of scale has led to the existence of multinational companies. Emerging trade
patterns in hyper-globalization find a good explanation from this model as most of the
trade took place between different units of these corporations. With trade gains going
to these corporations, trade patterns also flowed in the direction desired by MNCs.

4.6. Effect of Trade on Growth

In both the traditional and new trade theory, the effect of trade on growth did not
find any space. Work in this field was first given by J. R. Hicks, which states that even
in the HOS world, due to different income elasticities of goods in countries, income
growth can differ from output growth. Assuming a technology stimulus, which causes
a parallel outward shift of PPC, i.e., the same increase in exports and imports leads to
increased income in the economy. In this case, an increase in income can be more and
less than output depending on the different income elasticities for exportable and
importable. This work was extended by Bhagwati (1958) in “Immiserizing Growth”
model, which explained how technology growth in exportable goods and lower-income
elasticities of exportable goods could negatively impact the terms of trade. In this
scenario, income growth is less than output growth, and income is absolutely less
because of decreased prices. Thus, under this model, technological progress has shifted
the terms of trade against your country. Prebisch and Singer's hypothesis provided a
further breakthrough in this field. Their hypothesis states that there exists a long-run
tendency for terms of trade of primary commodities to deteriorate. It has been observed
that countries exporting primary commodities have seen a decline in their terms of
trade. This is consistent with the argument that global supply is not fixed, and when
some resource becomes scarce, its substitute becomes available in the market. It is the
contribution of policies of agriculture protectionism followed by countries advocating
free trade and the decline in demand for intermediate/ primary goods by developed
countries from developing countries that has led to the underdevelopment of these
countries.

4.7. Dutch Disease and Curse of Natural Resources

The presence of natural resources does not make a pleasant story in terms of trade.
It has been observed that countries with natural resources specialize in exports of
natural resources, considering the initial gains they receive from exporting such
commodities. Still, over time their terms of trade deteriorate. This is the core of Dutch
disease. After finding petroleum, the Dutch specialized its export in petroleum, shifting
their resources from other sectors to petroleum, which corrected trade terms and
boosted the growth rate and subsequent demand for the coming period. Still, after the
petroleum reserve went over, they could not switch to their earlier manufacturing
industries. This is because of the implication of learning by doing (Arrow, 1962). We
know that we learn by doing more, but as we stop doing something, we even lose our
existing knowledge in that field. This is why it is called a curse of natural resources.
This is discussed in detail in the “Dynamic competitive advantage” model. According
to this model, we need to carefully select the industry for specialization, and our
decision should not be based solely on static returns to scale. Still, it should also give
thought to dynamic returns to the scale of the industry. Once we enter the constant
return to scale industry of natural resources, we are left with fewer resources and space
to diversify our economy to other goods.

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4.8. Trade Theories for the 21st Century

Going through the above models, it is apparent that the new trade theory calls for
free trade but with a few steps of caution. Abuse of power by developed nations has
resulted in two different approaches to trade policies. With developing nations forced
to follow the traditional suite of free trade doctrine through bilateral trade negotiations
and multilateral institutions, developed nations' police are centered on strategic trade.
The current economic paradigm's ability to maintain the inequality gap has supported
the asymmetrical combination of policies. This combination of policies determines
trade in the modern world. Your position in the world makes you fall in either group,
forcing you to pursue the respected trade policies. Current models have used simplified
notions to understand this dynamic process in a complex world. We now need to
introduce more realistic models, embedding the issues of political strategies,
macroeconomic view, inequality, etc., in the trade theories.

5. CONCLUSION(S)
Countries engage in international trade for two basic reasons, each of which
contributes to their gains from trade. Because each country is different from other countries
in terms of factor endowments, technology, geography, natural resources, and human capital
and they want to achieve economies of scale in production (Krugman & Obstfeld, 2003).
Hence, trade take place among the countries. According to classical trade theories, Ricardo
knew that if England opened to free trade, it would benefit the workers who worked in
England’s cloth industry but hurt the aristocrats who owned most of England’s agricultural
land. But still, his theories are powerful and excellent at explaining why trade occurs
between countries that specialize in very different types of products.
Heckscher-Ohlin model has widely used in trade policies, but very little empirical
evidence supports this model. This model's assumptions failed to cope with the realities of
the world. Even with the trade, there is no evidence of prices getting equalized across
countries. Leontief's paradox indicated that most of the trade happens between similar
countries. US import substitute goods consisted of capital-intensive goods, while exports
were labor-intensive. After this, various explanations have been given, citing the skilled
labor force of the US, which is in demand compared to its trading partners. Further, the
desire for varieties produced by the same industries opens space for Intra industry trade.
Technology and FDI also find an adequate existence in trade theories explaining the pattern
of trade. With trade gains going to the corporations, trade patterns also flowed in the
direction desired by MNCs.
The Dutch disease witnessed that the presence of natural resources does not make a
pleasant story in terms of trade. It has been observed that countries with natural resources
specialize in exports of natural resources, considering the initial gains they receive from
exporting such commodities. Still, over time their terms of trade deteriorate. In twenty first
century, we now need to introduce more realistic models, embedding the issues of political
strategies, macroeconomic view, inequality, etc., in the trade theories. There is a major
discord between WTO members on issues relating to data flows and data localization.
(Nivedita, 2018). The basis of trade entirely based on the purpose of trade and economic
efficiency of nation in terms of demand and supply. But the comparative cost theory of
international trade is still unchallenged and valid for almost all kinds of circumstances
among trading nations.

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